Fitch upgrades Cyprus to BB+

Fitch Ratings has upgraded Cypruss Long-Term Foreign-Currency Issuer Default Rating (IDR) toBB+fromBB` with a positive outlook. The rating is just one step before the investment scale.

Fitch said that future developments that may, individually or collectively, lead to an upgrade include the reduction in banking sector NPEs that materially reduces the sovereign`s contingent liabilities, track record of declining GGGD/GDP ratio and continued deleveraging of the private sector.

It notes that it does not currently anticipate developments with a high likelihood of leading to a downgrade. However, it says that future developments that may individually or collectively lead to negative rating action include failure to improve asset quality in the banking sector and deterioration of budget balances or further materialisation of contingent liabilities that results in the stalling of the decline in the government debt-to-GDP ratio.

In its key assumptions, it notes that gross government debt-reducing operations such as future privatisations are not considered in Fitch`s baseline scenario. The projections also do not include the impact of potential future gas reserves off the southern shores of Cyprus, the benefits from which are several years into the future.

Fitch says that it does not expect substantial progress with reunification talks between the Greek and Turkish Cypriots over the next quarters, noting that the reunification would bring economic benefits to both sides in the long term but would entail short-term costs and uncertainties.

It says that Cyprus`s external financing flexibility has improved substantially since the country exited the macroeconomic adjustment programme in March 2016.

«The government tapped international markets in June 2017 and external interest payments are set to decrease to 6.6% of current account receipts in 2018-2019, down from an average 16.2% in 2011-2012. Cyprus is also attracting large foreign direct investments in the construction, tourism, energy and education sectors. Cash reserves were EUR1.2 billion at end-2017 covering expected gross financing needs for 2018».

Recently published data from the Central Bank of Cyprus (CBC) indicate that external sector statistics are materially distorted by special purpose entities (SPEs), including shipping and financial companies.

«We expect the large import-content of investments will keep weighing on the current account deficit, which we project at about 6% of GDP in 2018-2019, compared with aBBmedian of 3.2%, but it would be significantly lower when excluding SPEs, as per the CBCs estimates. Similarly, net external debt (NXD) excluding SPEs would turn into a small net asset position of less than 3% of GDP in 3Q17 according to the CBC, compared with a non-adjusted NXD of 164% of GDP at-end 2017 and a BB median of 13%».

Fitch says that Cyprus`s fiscal performance has benefited from a very strong cyclical economic recovery, and prudent fiscal policy.

«We forecast the government will continue recording fiscal surpluses of 1.1% of GDP in 2018 and 2019, after over-achieving its fiscal target in 2017 with an estimated surplus of 1.9% of GDP, compared with a BB median fiscal deficit of 3.2%. A dynamic labour market and sustained economic momentum will support revenues while the recent agreement with trade unions limiting the payroll rise to nominal GDP growth and the hiring freeze adopted in the public sector will help contain current spending».

As far as medium-term debt dynamics is concerned, they point towards a firm downward trend, which will provide Cyprus with some fiscal room to absorb any materialisation of contingent liabilities arising from the banking sector, Fitch says, adding that strong nominal GDP growth, at a forecast 4% over the medium term, ongoing expected primary surpluses and a very gradual increase in nominal effective interest rates will lead to a decline in the gross general government debt (GGGD)/GDP ratio to less than 90% by 2022.

«We expect real GDP growth to remain robust in the coming years and average 3.4% in 2018-19, supported by a dynamic tourism sector and buoyant construction activity. Private sector debt and non-performing exposures (NPEs) remain high and are still weighing on new lending, but we believe economic growth would be resilient to a possible acceleration in NPEs normalisation. The recovery relies largely on foreign-financed investments, which should minimise any contraction in domestic demand. Householdsdeposits are also substantial at 123% of GDP at end-2017, twice the stock of households housing loans, and strong employment growth and rising wages would help smooth private consumption if debt service costs were to increase».

Furthermore it says that deleveraging of the private sector is ongoing, with households` and corporate debt (excluding non-financial SPEs) declining by 5pp in 3Q17 to 250% of GDP adding that increased earnings, ongoing resolution of mortgage arrears, recovering house prices and upcoming legislative reforms enhancing the foreclosure and insolvency framework might foster further debt repayment.

According to Fitch, CyprussBB+IDRs also reflect the following key rating drivers mainly that the weakness of the banking sector remains a risk to public finances and weighs on Cypruss credit profile.

«The government deposited EUR2.5 billion in Cyprus Cooperative Bank (CCB) in April 2018 to alleviate depositorsconcerns ahead of the expected sale of the states majority stake in the bank and following a recent outflow of deposits from CCB. We expect this to lead to an increase in the GGGD/GDP ratio to 104% of GDP in 2018, from 97.5% in 2017″.

In addition, it says that the Cypriot authorities intend to launch a new «Estia» scheme which would apply to the banks` problem housing loans to vulnerable groups, currently estimated at EUR3 billion.

«The scheme will rely on loan restructurings and state subsidies to incentivise borrowers` repayment and would imply an estimated yearly fiscal cost of 0.25% of GDP over the medium term».

Noting that the ratio of NPEs to total loans declined gradually to 42.5% at end-2017 (109% of GDP), down from 46.4% at end-2016, it adds that the decline stems from rising repayments, debt restructuring, loan write-offs and large recourse to debt-to-asset swaps.

However, Fitch says, developments were uneven across banks, as the country`s two largest domestically-oriented banks, Bank of Cyprus (BoC) and Hellenic Bank (HB) progressed faster than its cooperative sector, where NPEs were 59% of total loans at end-September 2017.

Regarding capitalisation, it notes that it remains above regulatory requirements but decreased in 2017, with common equity Tier 1 declining by 1pp to 14.9% as banks increased their provisioning and recorded some losses.

«Unreserved NPEs for the sector amounted to EUR11 billion (57% of GDP) at end-2017, which could lead to some capital shortfall if losses were to crystallise and higher than expected haircuts were incurred when liquidating underlying collateral. This level of NPEs is very significant relative to the overall banking sector common equity Tier 1 capital of EUR5.4 billion at end-2017».

As far as liquidity it concerned, Fitch says it has improved as denoted by the repayment of ECB emergency liquidity assistance balance in 2017 and deposits increased by 3.1% y-o-y to EUR49.4 billion in December 2017.

«However, non-resident deposits still represent a quarter of total deposits at BoC and a half at HB. These are largely short-term funding and confidence-sensitive and would likely become more volatile than domestic deposits in case of stress,» Fitch concludes.